Japan: Two arrows too many Global Economic Outlook, Q4 2016

The Bank of Japan seems to have run out of moves to strengthen the economy through monetary policy. Quantitative easing and negative interest rates have had little effect. Now the bank is targeting the long end of the yield curve by keeping 10-year bond yields close to zero.

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Remember that time from childhood when you ran out of tricks to sneak another muffin from the kitchen? Well, it appears that the Bank of Japan (BOJ) is sharing a similar fate. As it announced its new policy stance on September 21, one could not help but wonder if the central bank had indeed emptied its ammunition. Be it quantitative easing or negative interest rates, the BOJ for a long time now has been at the forefront of using unorthodox monetary policy to counter deflation and prop up the economy. So, as it declares that its next target is the long end of the yield curve, it is worth thinking whether the BOJ has been trying too hard for too long.

Be it quantitative easing or negative interest rates, the BOJ for a long time now has been at the forefront of using unorthodox monetary policy to counter deflation and prop up the economy.

Flipping as they flop?

In addition to its annual asset purchase program—commonly referred to as quantitative easing (QE)—and negative interest rates, the BOJ has now decided to target the long end of the yield curve. In short, the BOJ wants to keep 10-year bond yields close to zero.1 The move is not surprising given fears of a prolonged period of below-zero long-term interest rates, which have dented banks’ margins—interest earnings on bank loans (or assets) are dependent on long-term interest rates—and the earnings of pensioners who depend on long-term fixed-income assets.

Not surprisingly, the latest BOJ move has lifted bank stocks, which have been under pressure since the advent of negative interest rates. After the BOJ’s decision, the Topix Banks Index went up 7.0 percent by end of day on September 21, the highest single-day gain for the index since February. Prior to September 21, the index had lost 27.1 percent this year, much worse than the 12.7 percent decline in the overall Topix Index (figure 1).2

Figure 1. Bank stocks have been hit this year due to negative interest rates

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The BOJ, in its monetary policy meeting, also tried to reassert its commitment to fight deflation. The central bank stated that, if required, it would let inflation overshoot its 2.0 percent target. It’s not clear, however, what new measures it will use in future. But, if one is to go by Governor Haruhiko Kuroda’s actions—aggressive QE and then negative interest rates—then something similar to using perpetual bonds to fund government spending cannot yet be ruled out.3

Not much succor from negative interest rates so far

The BOJ’s latest gambit comes amid concerns about a number of advanced nations’ overdependence on monetary policy.4 The central bank, in particular, may be trying too hard, when economic theory suggests that monetary policy alone cannot bring in medium- to long-term growth.5 The data also raise questions regarding the efficacy of continued unorthodox policy. The BOJ’s policy of negative interest rates, for example, has not had much impact of late compared with the initial phase of aggressive QE since Kuroda took over in 2013.6 For starters, the country continues to grapple with deflationary pressures. Core inflation—all items except fresh food as defined by the BOJ—has been flitting in and around negative territory since July 2015 and for much of 2016. In fact, core inflation in July (-0.5 percent) was the lowest in more than three years. The aggravation of deflationary pressures hints at the lack of impact of unorthodox monetary policy, especially negative interest rates, this year (figure 2).

Figure 2. Deflationary pressures are once again asserting themselves

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The aggravation of deflationary pressures hints at the lack of impact of unorthodox monetary policy, especially negative interest rates, this year.

If the BOJ had thought that a barrage of cheap money will force demand up sharply through credit offtake, then so far it has been proved wrong. Growth in loans outstanding from domestic banks, for example, was 2.4 percent year over year in Q2, down from 2.8 percent in Q1 and 3.4 percent a year before. A deeper analysis of the distribution of loans by sector—manufacturing, nonmanufacturing, and individual—also highlights a similar story.7 That the steady binge of unorthodox monetary policies, including negative interest rates, has not done much is also evident from diverging trends in the growth of broad (M3) and narrow money (M1) this year (figure 3).

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Slow credit growth despite easy credit conditions is primarily the result of households and businesses remaining circumspect about borrowing and spending more. In an aging society, consumers are still grappling with slow earnings growth, a deflationary environment, and uncertain economic prospects. Monthly real and nominal household expenditure growth (year over year), for example, has been negative for much of the year.8 And in Q2, real household consumption growth slowed to 0.6 percent (seasonally adjusted annual rate, or SAAR) from 2.8 percent in Q1.

In the midst of volatile and weak consumer spending, it would be wrong to assume that businesses will invest more. Corporates are opting to hold on to cash rather than spend. Real private nonresidential investment, for example, contracted in both Q1 and Q2 (SAAR) despite healthy corporate profits.9 Japanese businesses are also grappling with declining exports; real exports fell 5.8 percent in Q2. A strengthening Japanese yen has not helped. While the initial bout of QE helped weaken the currency and boost exports as the BOJ had hoped, the bout of yen weakening has run its course. In 2013 and 2014, the yen fell 16.4 percent and 12.9 percent, respectively, against the US dollar. But last year, it remained almost unchanged. And despite aggressive QE and negative interest rates this year, the currency is up 16.9 percent against the greenback (figure 4).

Figure 4. The yen has strengthened 16.9 percent against the US dollar this year

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The yen’s strength has also dented the BOJ’s fight against deflation. Due to the yen’s gains, import prices in yen have dropped by anywhere from 17.9 to 23.3 percent year over year in the first eight months of this year. This, in turn, has put downward pressure on consumer prices.

Negative interest rates have also impacted money market liquidity. In February—a month after the introduction of negative interest rates—the average amount outstanding in money markets (uncollateralized) during the month fell 39.5 percent, with market participants caught unawares. Unfortunately, the scenario has only worsened since then (figure 5).

Figure 5. Money market liquidity has been hit due to negative interest rates

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The continued purchase of Japanese government bonds by the BOJ also raises concerns about the stability of government debt (more than 250 percent of GDP) and the BOJ’s balance sheet. The latter now owns about 38.0 percent of the total Japanese government bonds, and this will go up given the ongoing QE.10 With the government postponing its fiscal targets, questions about the sustainability of debt naturally arise. That can change, however, if a sizable portion of the debt that the BOJ owns is changed to a zero-coupon perpetual bond.11 Of course, such a move will not be without controversy, as it will amount to some form of monetization of government debt.

No third arrow even now

To restore growth in the face of the fading impact of monetary policy, Prime Minster Shinzo Abe announced a fiscal stimulus measure of 28 trillion yen in July. So will the fiscal magic work where the monetary one has not? Not likely, if medium- to long-term growth is the issue. While the stimulus has come at the right time—when economic growth is faltering—the new fiscal package falls short on a number of issues:

Like previous measures, the immediate spending component is smaller than the announced package.12 Only 13.5 trillion yen is dedicated to new measures, with new spending of 7.5 trillion yen likely this year and the next. The remaining 6.0 trillion yen will be in the form of loans.13

A large chunk of the announced stimulus will be used for infrastructure (such as ports and Maglev trains), while some of it will be directed toward disaster relief. Spending on these projects would have happened in some form or the other even without the stimulus.

The fiscal package misses out on productivity-enhancing investments. Productivity has been stagnant in Japan, a major worry given the country’s aging population and labor force.

What has been absent throughout has been Abe’s third arrow: structural reforms. For example, there has been no major move so far to deregulate the labor market and make key services sectors more competitive. There is also no big measure to reform corporate governance, essential for enhancing economic competitiveness. And, although Abe announced a 3.0 percent hike in minimum wages, there is no frontal push yet to force businesses to raise wages—key to higher consumer spending. Most importantly, subtle efforts to raise female participation in the labor force—critical for potential GDP growth—have not made much headway. With so much still to do, it’s not surprising that repeated fiscal stimulus and monetary easing are not making much of an impact. If the yen’s movement is anything to go by, the BOJ’s move on September 21 definitely falls short. After declining initially, as the BOJ would have hoped, the currency climbed up again later to end the day just 0.1 percent lower against the US dollar. It’s imperative then that Abe release his third arrow to regain momentum. Mere promises won’t suffice.

What has been absent throughout has been Abe’s third arrow: structural reforms. For example, there has been no major move so far to deregulate the labor market and make key services sectors more competitive.

Credits

Acknowledgements

The author would like to thank Nobuhiro Hemmi, partner and head of Global Business Intelligence at Deloitte Tohmatsu Consulting, Japan, for his contributions. Hemmi is also a member of the Deloitte Global Economist Council.